Starbucks: What's Going To Drive Further Results?

Premium valuation is aided by external environment

Feb 4, 2014 at 7:43AM

Investors in Starbucks (NASDAQ:SBUX) had a great run in the past few years after founder Howard Schultz returned after serious struggles in the company's growth path emerged, notably on the back of increased competition.

The market has more than recognized this recovery, and attached a premium valuation to the coffee conglomerate, should make it easier for a potential investors to await better entry levels.

First quarter results
Starbucks reported revenues of $4.24 billion in the first quarter, up nearly 12% compared to a year earlier. Growth was driven by a 5% increase in comparable sales as well as new store openings. Pricing was relatively soft, increasing by just 1% as increased traffic explains the remainder of top line growth. 

That being said, sales were a bit soft which the company attributed to a weaker US consumer sentiment and the pronounced impact of more online shopping. Note that Starbucks generates nearly three quarters of its total revenues in the US retail segment. 

Solid revenue growth allowed Starbucks to increase margins as well as operating earnings rose by 2.6% to 19.2% of total revenues. These are historically high margins for the firm as it is benefiting from economies of scale, lower coffee costs and strong pricing power. Of course, such margins for a relatively "simple" industry are very attractive which might results in greater competition going forwards and this could of course have an impact on future margins.

Reducing reliance upon coffee and America
While offering plenty sorts of coffees, Starbucks remains relatively narrowly focused on coffee with a major focus on the US. To counter this reliance, the company is targeting roughly 1,500 store openings in 2014, half of which will take place in the Asia-Pacific region. 

Besides geographical diversification, the company focuses on other drinks and snacks as well. With the acquisition of TeavanaStarbucks is boosting its tea offerings. Recent other offerings and acquisitions make the company focus on healthy juices and bakery products as well.

Competition is not sitting still
Competitors have noticed the success of the company in recent years, and have tried to benefit as well from the increased appeal of coffee to Americans. While Starbucks has been able to ride a "millennium" trend, some of its largest competitors are failing to do so. McDonald's tried to sell premium food or even discounted coffee through its McCafe, but largely fails to compete effectively with Starbucks. An image problem and the failed offering of an out of office "working" place might be to blame. 

More direct competitors include Dunkin Brands Group (NASDAQ:DNKN) which offers ready to drink coffee in its stores and Green Mountain Coffee Roasters (NASDAQ:GMCR) which competes with the channel development business of Starbucks. Both businesses lack scale, organizational and financial resources to effectively compete with Starbucks now. These competitors have a market capitalization which is respectively 15 and 5 times smaller than that of Starbucks. 

McDonald's might be a worthy competitor one day if it manages to find a good recipe to compete more effectively, which will most likely have to come from a changed image, store layout, or even a separate chain. For now, Starbucks remains its biggest own enemy. High prices remain tricky and can backlash if the economy tanks, as it remains a premium brand.

Premium coffee, premium valuation
Starbuck's earnings are driven by three main factors in recent years. This includes a solid organic growth rate, although it is inching down in the recent quarter. Other drivers continue to be store openings, notably in China and Asia, new product offerings and increased operating margins through sales leverage and lower coffee prices.

As such the firm had major positive drivers from the external environment in recent years, which might not always remain the case in the future. The solid momentum has pushed up the valuation to $54 billion at a share price of $71 per share.

At roughly 27 times earnings I have no taste paying a premium valuation for the stock as well. While growth is still solid, it could slow down meaningfully anytime on higher coffee costs, a slower economy or increased competition, which will undoubtedly have a great impact on the price-earnings valuation.

I

Fool contributor rhp broens has no position in any stocks mentioned. The Motley Fool recommends Green Mountain Coffee Roasters and Starbucks. The Motley Fool owns shares of Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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